Interaction between the four basic financial statements



Accounting was defined by the AICPA (1953) as "the art of recording, classifying and summarizing … transactions and events which are, in part, financial and interpreting the results" (para.1). Accounting may be defined as an art, it has been observed to use scientific methods. A more comprehensive definition of accounting by Ansari, Bell, Klammer and Lawrence (1997, p.2) consists of four key concepts: the nature of accounting as a measuring process; its scope which encompasses operational and financial information; the purpose of accounting which is assisting organisations in achieving their strategic objectives; and its attributes which are to foster the comprehension of the measurement phenomena and to provide information to be used in decision making.

Purpose of accounting

Accounting is viewed as a language that is utilized by organisations in decision making. Thus, accounting has continued to exist due to its usefulness in to the society at large and to a narrower context, to the users of accounting information. The users of accounting information can be divided into two; internal and external users. The management and employees are the internal users of accounting information; they use it for operational, administrative and strategic purposes. External users are; investors, suppliers, creditors, customers, the government and the general public.

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Financial statements (also known as financial reports) are formal records used for storing financial activities of a person or a business entity. For a business entity, all the required financial information that is presented in a formal manner such that it can easily be understood is referred to as a financial statement. There are typically four basic financial statements, these include:

The balance sheet, also known as the statement of financial position or state. The balance sheet reports on a firm's assets, liabilities and capital at a particular point in time;

The income statement: also called the Profit and Loss account ("P&L"). The income statement reports on a firm's income, expenditure, and profits or losses over a particular period of time. The P& L account provides information on a firm's on operation activities such as sales and the various expenses incurred by the firm during the state of processing;

Statement of retained earnings, this explains the various changes in a firm's retained earnings over a financial period;

And finally we have the statement of cash flows. As the name suggests, this reports on a entity's cash flow activities, in particular activities involving operations, investments and those that are financial in nature.

Interaction between the four basic financial statements

First, there is the Income Statement. The profit and loss and loss account displays how profitable a firm is. Having a positive net income simply means that the company is making money. On the contrary, having a negative net income is a sign that the firm is operating at a loss. The income statement is prepared using accounting entries involving revenues and expenses over a financial period. The interrelation of financial statements can be explained using the accounting equation. The accounting equation is stated as Assets = Liabilities + Capital. In the accounting equation, Capital consists of revenues and expenses. From the accounting equation, revenue increases owner's equity while expenses decrease capital (the money invested in the company by the owners). Since the firm's balance sheet is based on the accounting equation, and the owner's equity being a component of the balance sheet, this is its connection to the income statement. Secondly, there is the Statement of Retained Earnings. This is developed after the Income Statement utilizes data from the Income Statement. Normally, the net profit (as obtained from the income statement) is either retained or paid out in terms of dividends or both actions are taken by firms. Thirdly, we look at the Balance Sheet and the Accounting Equation. As discussed above, the balance sheet shows the net worth of a firm. Both sides of the balance sheet have to tally every asset is purchased with either a liability, or Capital, such as a part a firm's retained earnings. The profit and loss account is an indicator of profitability while the balance sheet represents the net worth of a company. Finally, there is the Statement of Cash Flows. This uses data obtained from both the income statement and balance sheet. This particular statement is developed last of all the statements.

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Importance of financial statements to their users

The objective of preparing financial statements is to present information about a company showing their performance, financial position, and the changes in their financial position that are useful to several of such statements in making economic decisions. In order to be relevant, financial statements should be reliable, understandable, and comparable. Financial statements will report on assets, liabilities, capital, profit and losses that are directly related to a firm's financial position, they are intended to be understandable by users who comprehend accounting principles as used in businesses. Financial statements are used by users for different purposes. These include; Investors and managers use financial statements to make critical business decisions that directly impact on their continued operations. These statements are analyzed is to give the management a more detailed understanding of the numbers. Financial statements form part of the management's annual report to the shareholders. Employees need financial reports for making agreements with the management; this is mostly for labor unions in discussing compensation matters. Prospective investors utilize financial statements in assessing business viability. This is usually done by financial analysts to help investors in decision making. Financial institutions use financial statements in decision making on credit issuance to companies. Government entities use financial statements in ascertaining the accuracy of taxes and other duties that are paid by a company. Suppliers who usually extend credit to a company use financial statements in assessing the creditworthiness of the business entity. Finally, the media and the general public interests in financial statements such as whether the company is contributing to social welfare.


It is clear that financial statements form part of the firms activities and firms are required by the law to prepare and present financial statements are often as possible. The four basic financial statements used by firms are; the income statement, the balance sheet, the statement of retained earnings and the cash flow statement. All these statements are interrelated and are prepared in the above order. Financial statements are of interests to various stakeholders such as investors, the government, and financial institutions among others.